Pension funding statements

Members of occupational pension schemes are being sent statements that explain the funding position of their schemes. Many will be shocked to see that the funding looks very low. More than 10m statements will be sent out by private sector employers, according to Mercer, a human resources consultancy. About 2m will be sent to active scheme members – those who are still working – while 4m each will go to pensioners and people who have deferred drawing a pension from a previous employer.

Why have I been sent a funding statement? I do not recall being given this information in the past.

Most occupational pension schemes are required to send summary funding statements to their members by September 22. This is a legal requirement resulting from the Pensions Act 2004 and is intended to improve communication between schemes and their members. Some pension schemes already tell members what proportion of their benefits are covered by the scheme’s assets. But this is the first time they have been required by law to reveal the funding level. The statement must include two sets of numbers.

What do they mean?

The statement should include the funding level calculated on an “ongoing basis”, which assumes that the scheme will continue in operation. It should also include a figure that shows what percentage of the fund’s potential liabilities would be covered if the fund had to buy the same level of cover from an insurance company. Schemes that are 100 per cent funded on an ongoing basis usually have a much lower level of cover on an insurance buyout basis. “The statements could come as a shock to many members,” says Deborah Cooper, a principal at Mercer. “It is rare for trustees or companies to disclose their scheme’s funding position on an insurance buyout basis.”

Why would my scheme need to buy cover from an insurance company?

If the company and the trustees were to wind up the scheme they would go into the insurance market and buy cover. If the company went bust, the Pensions Protection Fund would see if its liabilities could be covered by an insurance buyout.

Why is the cover provided by an insurance company so much less than the funding level while it remains “in house?”

Insurance companies adopt a much more cautious approach to the cost of providing cover. If the employer offering the pension scheme is still around, the trustees can always seek additional contributions from that source – an option not open to the insurance company. Regulation also adds to the insurers’ costs. Most scheme members can expect to receive between 50 and 70 per cent of their expected benefits if their employer was forced to buy an insurance policy, says Mercer.

My employer seems to be strong financially and the level of funding on the pension scheme looks reasonable. Does this mean I have nothing to worry about?

Not necessarily. The trustees and their advisers use certain assumptions in calculating the scheme’s strength. They can make it seem stronger through optimistic assumptions about future investment growth. If they are assuming a very high return above a benchmark yield on risk-free UK government bonds (gilts) they could be fooling themselves. Any assumption of two percentage points or more above the current gilt yield of around 5 per cent looks too optimistic. However, schemes with lots of younger members are likely to be more heavily invested in equities, which should deliver a higher return. More mature or closed schemes will include a larger percentage of gilts and corporate bonds and should therefore assume a lower annual return.

To see if the trustees of your pension fund are being optimistic, compare their numbers with those in your employer’s annual accounts. There, investment returns will be calculated according to the FRS17 accounting standard which bases growth assumptions on the yields of double-A rated corporate bonds. The FRS17 figure is likely to be between the ongoing fund basis and the insurance buyout figure.

Whichever measure I use, my scheme looks underfunded. Does this mean I should be worried about the ability of my scheme to pay my pension?

No. The statements are only a snapshot of the scheme’s position at one point and the shortfalls should reduce as contributions flow in.

What if my employer goes bust and my pension scheme folds?

You should be covered by the Pension Protection Fund if your scheme got into difficulty after April 6, 2005. Your pension will be met in full (with no upper limit) if you are already retired. But people who are still working will receive a maximum of 90 per cent of their pension and the total will be capped at £26,050 a year. For this reason, some people have transferred out of company schemes into self-invested personal pensions though transfer values need careful scrutiny.

I have not received a letter from my pension scheme. What does this mean?

Some trustees have been unable to meet the September 22 deadline so they will be required to explain themselves to the pensions regulator. A small number have been given an extension to fit in with the timing of their scheme valuations.